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Section 954(c)(6) provides that Subpart F foreign personal holding company income (FPHCI) generally does not include dividends, interest, rents, and royalties received or accrued from a related CFC. Such items qualify for the exception, however, only to the extent they are attributable or properly allocable to income of the payor CFC which is neither Subpart F income nor income treated as effectively connected with a U.S. trade or business.¹

The Tax Technical Corrections Act of 2007 (“2007 TTCA”)² includes an amendment that “clarifies” the coordination of the §954(c)(6) look-through exception with the §952(c) deficit rules. Under new §954(c)(6)(B), the look-through exception does not apply to interest, rents, or royalties to the extent such item creates (or increases) a deficit which under §952(c) may reduce the Subpart F income of the payor or another CFC.³

Section 952(c)(1)(B) provides that Subpart F income from a qualified activity (e.g., an activity giving rise to foreign base company sales or services income) may be reduced by a prior year deficit of the CFC attributable to the same activity. In addition, under §954(c)(1)(C), a CFC may elect to reduce its Subpart F income attributable to a qualified activity by the amount of any current year deficit attributable to the same qualified activity of another CFC in a specified chain of ownership. New §954(c)(6)(B) provides that interest, rents, or royalties that give rise to such a “qualified deficit” are not eligible for the look-through exception.

Example. CFC1 has $500 of gross foreign base company sales income. CFC1 has expenses directly related to the sales income of $400. CFC1 pays $200 of interest to CFC2 that is apportioned to the sales income. As a result, CFC1 has a $100 deficit attributable to a qualified activity. Under the 2007 TTCA, none of the $200 of interest paid by CFC1 to CFC2 qualifies for the look-through exception, even though $100 may be considered as not reducing current year Subpart F income but instead creating a deficit.

This result is appropriate because such $100 deficit may be effectively carried forward to reduce CFC1's Subpart F sales income in a subsequent year, or used to reduce current Subpart F sales income of another CFC in the same chain of ownership.

The technical correction does not apply to an expense that creates a loss that results in the amount of current year Subpart F income of the CFC payor being reduced under §952(c)(1)(A). That provision states that the amount of a CFC's current taxable year Subpart F income cannot exceed its total earnings and profits for the taxable year. This limitation may apply, for example, where the CFC has losses resulting from its non-Subpart F activities. The amount by which Subpart F income is reduced under this limitation is subject to recapture in a subsequent year when the CFC earns non-Subpart F income.⁴

Example. CFC1 pays interest to CFC2 during 2007 in the amount of $200. CFC1 has $100 of gross Subpart F services income and $300 of gross non-Subpart F sales income. The $200 of CFC1's interest expense is apportioned $50 to its Subpart F services income and $150 to its non-Subpart F sales income. Other expenses in the amount of $180 are directly allocated to the non-Subpart F sales income, resulting in a $30 loss ($300 - $180 - $150), and no other expenses are allocated or apportioned to the services income. Accordingly, under §952(c)(1)(A), the $50 of net Subpart F services income is limited to $20, since CFC1's earnings and profits are $20 ($50 - $30). Under §954(c)(6), $50 of the interest received by CFC2 should not qualify for the look-through exception because it is apportioned to the Subpart F services income, but the $150 apportioned to the non-Subpart F sales income should qualify for the exception.

Appropriately, new §954(c)(6)(B) should not apply to the $30 of interest expense that may be considered as resulting in a reduction of CFC1's earnings and profits that limits the amount of current year Subpart F services income to $20, because such $30 is subject to recapture as Subpart F income in a subsequent year when CFC1 has net non-Subpart F income.

The limited applicability of new §954(c)(6)(B) to only qualified accumulated deficits and qualified chain deficits is clear not only from the statutory language itself, but also from the legislative history, which describes the amendment as follows:

Thus, interest, rents and royalties will be treated as Subpart F income, notwithstanding the TIPRA look-through rule, if the payment creates or increases a deficit of the payor corporation and that deficit is from an activity that could reduce the payor's subpart F income under the accumulated deficit rule (sec. 952(c)(1)(B)), or could reduce the income of a qualified chain member under the chain deficit rule (sec. 952(c)(1)(C)).⁵

There is no reference to the new exception applying to the current year earnings and profits limitation that is contained in §952(c)(1)(A).

It follows from the above that interest, rents, and royalties that are allocated or apportioned to non-Subpart F income should be eligible for the exception, even though the expenses exceed such income. This is expressly provided in Notice 2007-9, which states: “interest that is allocated or apportioned to income that is non-Subpart F income is eligible for the section 954(c)(6) exception … even if interest deductions exceed the gross income of the related CFC payor in the year paid or accrued.”⁶ As described above, the exception should apply even if the resulting loss limits the CFC's current year Subpart F income under §952(c)(1)(A).

This approach also is consistent with the application of the same country exception, which takes the exception away only to the extent the interest, rent, or royalty expense reduces the payor CFC's Subpart F income. The Joint Committee description of the technical correction states that--in this context at least--the two exceptions should apply in parallel: “For example, under the provision, items that do not qualify for the 'same country’ exception because they meet the terms of section 954(c)(3)(B) will also not qualify under the TIPRA look-through rule.”⁷

Consistent with the policy underlying the above rules, interest, rent, or royalty deductions that create a loss in a Subpart F income category for the year that is not a qualified deficit also should be eligible for the look-through exception.⁸ Such expenses, to the extent they exceed Subpart F income in a particular category, may not be used to reduce other Subpart F income.⁹ In addition, the resulting non-qualified deficit cannot be used to reduce future year Subpart F income nor be used by another CFC in a specified chain to reduce its Subpart F income.¹⁰

Accordingly, interest, rents, and royalties received or accrued by a CFC from a related CFC should qualify for the look-through exception provided that such payments do not reduce Subpart F income (or U.S. effectively-connected income) or result in a qualified deficit.¹¹

This commentary also will appear in the April 11, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 927 T.M., CFCs -- Foreign Personal Holding Company Income, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.